Friday, June 17, 2011

Caballero #2: Moral Hazard and Policy During a Crisis

Here's Caballero on why it's misguided, once a financial is actually underway, to worry that financial bailouts will create moral hazard incentives for high-risk behavior.

"I still recall politicians and economists calling for the need to teach lessons (in a punitive sense) to the financial system in the middle of the crisis. In fact, I think Lehman happened to a large extent due to the political pressures stemming from this view. What timing! ...

"I draw an analogy between panics and sudden cardiac arrest. We all understand that it’s very important to have a good diet and good exercise in order to prevent cardiac arrest. But once you’re in a seizure, that’s a totally secondary issue. You’re not going to solve the crisis by improving the diet of the patient. You don’t have time for that. You need a financial defibrillator, not a lecture. ...

The main dogma behind the great resistance in the policy world to institutionalize a public insurance provision is the idea that if the financial defibrillator were to be implanted in an economy, banks and their creditors would abandon all forms of a healthy financial lifestyle and would thus dramatically increase the chances of a sudden financial arrest episode.

"This moral hazard perspective is the equivalent of discouraging the placement of defibrillators in public places out of concern that, upon seeing them, people would have a sudden urge to consume cheeseburgers because they would realize that their chances of surviving sudden cardiac arrest had risen as a result of the ready access to defibrillators.

"But actual behavior is less forward-looking and rational than is implied by that logic. People indeed consume more cheeseburgers than they should, but this is more or less independent of whether or not defibrillators are visible. Surely there is a need for advocating healthy habits, but no one in their right mind would propose doing so by making all available defibrillators inaccessible. Such a policy would be both ineffective as an incentive mechanism and a human tragedy when an episode of sudden cardiac arrest occurs.

"I think this is one of the many instances when economists and politicians choose to solve a second-order problem they understand rather than focusing on what actually happens in real life."